When you plan to invest in a company, you have a choice to invest in different classes of stock, especially in case of multinational companies where an investor can decide to invest in dozen different types of securities. However, there are two commonly used stocks that are issued by companies, a common stock and a preferred stock. These stocks are entirely different from each other, and in order to understand the differences between them, it is important to know the strengths and weaknesses of both types of stocks.
Common Stock
Common stock represents the actual amount of capital paid or invested in a company by the investors. This stock provides the investor or holder an opportunity of voting in the annual general meetings to elect the board of directors. The voting rights are linked to the stocks, and usually it is equivalent to one vote per share. These stocks allow shareholders to take part in growth and profits of a business. There are two modes of income associated with common stock, the one that you get to earn in the form of dividend, and the other is through appreciation of wealth or value of the share.
Therefore, you can earn profits on common stock through capital gains. However, a company is not bound to make dividend payments every year. If a company suffers loss or is unable to make targeted profit in a particular year, shareholders may not receive any dividend in that year.
Preferred Stock
Preferred stock, also known as the preferred shares, are special financial instruments that serve both as equity and debt, and falls into the category of hybrid instruments. Specific payment terms are attached to preferred stocks, which is why these shares get priority over common stock at the time of liquidation, or when the dividends are distributed among the shareholders.
Difference between Common Stock and Preferred Stock
Distribution of Dividend – When a company earns profit, it becomes part of the retained earnings and the companies distribute a portion of their earnings among the holders of common stock. However, as already discussed, this distribution of profit is based on whether a company makes a profit or not. On the other hand, holders of preferred stock receive a guaranteed dividend at a pre-defined rate of interest that is agreed between the preferred shareholders and a company when shares are offered.
Voting Right – In case of a common stock, one voting right is attached with one share, and a shareholder can use his voting right to elect the board of directors at the annual general meeting. But, preferred stocks usually do not have any voting rights attached to it.
Liquidation of a Company – When a business is liquidated, preferred shareholders are given priority over holders of common stock, for example, in case a company goes bankrupt, preferred shareholders are compensated before common stockholders in the distribution of a company’s assets. This is the reason why venture capitalists mostly invest their money in preferred shares with a defined liquidation preference. So, after preferred shareholders are paid according to their defined preference, the remaining amount is paid to common stock holders.
Credit Rating – Preferred stocks are rated by credit agencies just like bonds, and the rating varies between a high quality investment stock and low quality, high yield stocks. On the other hand, common stocks are not rated by any credit agency.
The common stocks are more risky as compared to preferred stocks. A shareholder is always at a risk of losing all his investment, and he may also get a better chance to earn through capital gains. Whereas, preferred shares are comparatively less risky as they have a preference right over common stocks and have fixed repayment terms. Therefore, being an investor, you should always choose between these stocks on the basis of risk and reward relationship.
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